What is liquidity?

The term liquidity has now become a puzzle and an irritant for many. Mr David Longworth, Deputy Governor of the Bank of Canada, has given a wonderful speech on the subject.  He says there are 3 kinds of liquidity:

  • Macroeconomic liquidity, which has to do with “overall monetary conditions,” including interest rates, credit conditions, and the growth of monetary and credit aggregates.
  • Market liquidity, which refers to how readily one can buy or sell a financial asset without causing a significant movement in its price.
  • Balance sheet liquidity, which refers broadly to the cash-like assets on the balance sheet of a firm (or household). For non-financial firms, balance sheet liquidity is often measured by the short-term liquid assets on their balance sheet. For banks, which must manage their liquidity very closely, balance sheet liquidity is reflected in a detailed breakdown, by maturity, of their assets and liabilities – especially those coming due in the short term. The ability of banks to fund themselves is often referred to as funding liquidity.

The common element in these concepts is that liquidity is the ability to obtain cash – either by turning assets into cash on short notice or by having access to credit. He focuses on the first two. How to measure the two? 

The key indicators of macroeconomic liquidity, in terms of price, are the policy interest rates and the term structure of interest rates paid by borrowers. In terms of quantity, the key indicators are the growth of monetary and credit aggregates and the state of credit conditions more generally. In normal times, central bankers tend to place more emphasis on interest rates than on monetary and credit measures.  

So, the liquidity which is managed by central bankers is macroeco liquidity.  

Market liquidity refers to the extent to which one is able to quickly and easily buy and sell financial assets in the market, without moving the price. Market liquidity captures the aspects of immediacy, breadth, depth, and resiliency in markets. Immediacy refers to the speed with which a trade of a given size and cost can be completed. Breadth, often measured by the bid/ask spread, refers to the costs of providing liquidity. Depth refers to the maximum size of a trade for any given bid/ask spread. Resiliency refers to how quickly prices revert to fundamental values after a large transaction. 

That is pretty well said. J 

Hence, market liquidity has number of aspects and each one matters equally.  There may be depth and breadth in the markets but there could be times when immediacy and resiliency may not occur, as it was the case in sub-prime crisis.  

Generally speaking, the more liquid the market, the better. But there is an important caveat – if market participants come to expect that market liquidity will always be ample, and they acquire assets with the assumption that they can liquidate their positions quickly and at fairly predictable prices, they may end up taking on more risk than has been factored into the purchase price. And this could sow the seeds of a nasty correction in the event of a shock and a rapid decline in market liquidity. That said, liquidity is the lifeblood of markets. 

Both forms of liquidity have been increasing over the years. Macroeco liquidity because of low interest rates world over. And what keeps interest rates low- high savings by emerging markets.  Market liquidity has been low as bid-ask spreads have been low and low volatility in all aspects of financial markets.

Longworth adds it is because of new instruments, new players (hedge funds etc) and advances in tech that are responsible. He also suggests that Great Moderation and Globalisation are also important factors for increasing market liquidity.  Then he looks at how liquidity played a role in recent crisis and Canada’s response to the same. 

Read the whole thing. A nice primer.

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15 Responses to “What is liquidity?”

  1. IMF- euphemism at its best « Mostly Economics Says:

    [...] of liquidity mechanisms are at work and how comples things have become. For a primer on liquidity see this primer as [...]

  2. kabul Says:

    I read all it is perfect

  3. Md. Ashraful Islam Says:

    Thank’s

  4. Syed Zahid Ahmad Says:

    The classification of liquidity by Mr. David is interesting but impact of liquidity on macro economics need some inventions. Since market is going to get some more financial products like hedge fund, intetest rate derivatives, it has become more important for financial regulators to review the art of handling liquidity and its impact. Interest rate has far reaching impact on economic process and it has become more important to guage those impacts now becasue interest has generated by products which also create multi level effects. Mere changing interest rate to control liquidity may not work now. The liquidity in stock market is better for economic growth with stability in market while interest rate derivative will keep the market fluctuating without physical contribution to GDP.

    After all these developments in liquidity it is now important to compare value of liquidity byproducts in as proportionate to GDP becasue that is related to inflation and inclusive growth.

  5. The optimist Central Bank of Canada « Mostly Economics Says:

    [...] Somehow BoC’s statments on liquidity are the best (see this as well). What did they do to resolve the crisis? This explains all their work in [...]

  6. Handling Liquidity to control Inflation « Syed Zahid Ahmad’s Weblog Says:

    [...] Liquidity to control Inflation The classification of liquidity by Mr. David Longworth, Deputy Governor of the Bank of Canada is interesting, but we have to learn more about handling [...]

  7. Zerayehu Sime Says:

    Indeed, it is an impressive way of explanation and calls for further development to manage macroeconomic performance as well, leaving a question of Liquidity’s macroeconomic implications.

  8. Akande Philips Says:

    please can I get newsletter?

  9. cool tools Says:

    Thanks, I read all it is perfect

  10. Rosario Says:

    Very nice post.. Thanks for share :)

  11. Savings Says:

    I loved this post so much I’ve added it to my bookmarks and subsribed to your RSS feed, great work!

  12. world citie Says:

    Nice , thank you for this post..

  13. Angel Alo Says:

    Thanks for sharing your knowledge! Keep it up!

  14. breakdown cover comparison Says:

    breakdown cover comparison…

    [...]What is liquidity? « Mostly Economics[...]…

  15. Anuj Dahal Says:

    I liked this very much….. Thanks Deputy Governor, Canada

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